Debt is the least of Italy’s problems

Is it 2010 again? Back then, crisis meeting followed crisis meeting to save Europe’s monetary union from collapse.

The only differences are that those meetings a decade ago were not held by video conference and that the country most at risk was Greece, not Italy.

Oh, and there is another difference: The sums involved are larger than ever before.

On Thursday, the EU’s heads of government will meet virtually to discuss the fate of Italy. Only a week ago, Europe’s finance ministers had agreed to use the European Stability Mechanism (ESM), a fund created in the last crisis, to deal with the fallout of the Covid-19 pandemic.

But before that meeting, Italian Prime Minister Giuseppe Conte has put more pressure on his European counterparts. In an interview with Süddeutsche Zeitung, Conte emphasised his call for jointly issued bonds, so-called ‘Corona bonds’. These bonds, Conte told the German newspaper, would express the bloc’s solidarity in the crisis.

Conte also said he feared the funds from the ESM, estimated between 35 and 37 billion Euros, would come with strings attached. And, for that reason, he warned, it had a bad reputation in Italy: “We have not forgotten that the Greeks were forced to make unacceptable sacrifices in order to receive loans.”

In a way that probably was not part of his intention, Conte thus revealed the crux of the matter.

Whether the money for Italy comes from the ESM or from issuing Corona bonds does not really matter. Presumably, Conte would also accept it freshly printed from the ECB, as a bilateral loan or as manna from heaven.

The only thing that matters to Italy is that these funds do not compel Italy to do anything in return. There shall be no European demands for Italian fiscal policy or economic reform – niente.

By invoking the crisis spirit, Italy asks for a free fiscal lunch. No wonder other European countries are not keen to let this happen.

Still, what we are observing is just the prelude to what will be an epic battle over the future of the Euro.

Italian government debt stood at 2,446,893,000,000 Euro in February this year. That is 2.4 trillion Euro, which comes down to 41,322 Euro per person.

Whether Italy gets a few dozen billion Euros in aid, transfers or Corona bonds will not change the overall picture. The country is heavily indebted. Its debt load will continue to climb due to the Covid-19 crisis, and it is hard to imagine a scenario in which Italy would not at least partially default on its debt in the future.

So, yes, debt is a bit of a worry for Italy.

Still, I would argue debt is more a symptom of Italy’s real problem, not the problem itself. And that's also why I believe whatever kind of funding Italy receives will not make a difference at all. The only thing that would, is a substantial lift in Italian productivity.

Since the introduction of the Euro, Italy’s productivity record has been abysmal. According to the OECD’s labour productivity forecast, a comprehensive tool to estimate GDP per hour worked, Italy is one of the few countries that has seen this measure decline over the past 20 years (see figure).

(Source: OECD)

With productivity as poor as this, it is no wonder Italy did not generate much growth. And without growth, it is a challenge to keep debt stable, let alone pay it off.

But this is how the causal chain runs: It leads from poor productivity to poor growth to higher debt. Debt is the outcome, not the cause of Italy’s problems.

This then leads to the question of why Italian productivity is as low as it is.

There are many potential answers to this question, but two appear plausible. First, Italy never embarked on a comprehensive programme of economic reform. And second, its membership of the Euro did not allow it to at least claw back some of its lost international competitiveness through a devaluation of its currency.

Now Prime Minister Conte finds himself in a dead end:

His fiscal situation is so dire, he desperately needs some sort of European support.

His domestic political situation, meanwhile, prohibits him from accepting any demands for economic reform.

The funds he might receive will not prevent at least a partial Italian default at some stage.

No matter how much fiscal support he will receive, it will do nothing to reverse Italy’s productivity trajectory.

And for as long as Italy remains part of the Eurozone, none of the above issues can be resolved.

Thursday’s virtual EU summit will or will not find a compromise on the ESM vs. Corona bonds issue. But whatever the EU’s leaders agree, as long as Italy retains the Euro, its problems will remain as they have been for more than a decade.